With Oil Peaked For Now, Contrarians Likely Will Turn To Refiners

There aren’t many energy stocks sitting nearly 60% below their highs, but as the crude oil bull market has continued in 2008, refiners have gotten crushed. The explanation for why refiners fare poorly in the face of rapidly rising crude prices is pretty simple. Refiners buy crude oil, refine it, and resell it to users of gasoline and other refined products like jet fuel. If the price of your core cost component is soaring and end demand for your finished product is falling because of high prices curbing demand, profit margins will contract pretty aggressively.

As a result, shares of refiners such as Valero Energy (VLO) have been pummeled. After earning about $8 per share in both 2006 and 2007, profits for VLO are expected to fall 50% this year, to around $4 per share.

But what happens if crude oil stops going up so fast? Already we have seen per barrel prices top out in the 140’s and trade down to the low 120’s and gasoline prices nationwide are below $4 per gallon again. Frankly, the backdrop for refiners really can’t get much worse that is has been so far this year. As a result, VLO shares have fallen from a high of 78 last year all the way down to the 30’s.

There appears to be some value here if investors are willing to be patient and wait out a turn in refining industry fundamentals. Let’s value VLO stock two different ways and see what we come up with.

1) P/E Ratio Valuation

Let’s assume normalized EPS of $6 per share, up from the current run rate because conditions stand a good chance of improving, but 25% below the levels of 2006 and 2007. Use a 10 P/E and we get $60 per VLO share.

2) Asset Liquidation Valuation

Valero has sold 2 refineries since last year for about $3 billion. Those two refineries produced a total of 250,000 barrels per day. Valero now owns 16 refineries producing 3 million barrels per day. Let’s assume they sold all of their refineries for the same price. That would net them $36 billion, or $66 per share.

As a result of the tremendous value that appears to be embedded in the stock, VLO is being added to the Peridot Blog Model Portfolio today. Refining margins stand a good chance of improving over time, as long as crude oil prices behave better, which would likely positively affect VLO’s earnings per share, earnings multiple, and in turn, the share price.

Refiners have been in an environment where demand was essentially 100% of capacity. Once upon a time, they used to run less than full capacity in between driving season and winter. That’s over.

However, it appears possible that this situation is over. Permanently. Gasoline consumption is now declining in the US, which to my knowledge has not happened in my lifetime.

So the cornerstone of your thesis is a rearview look at past profitability and asset sales prices. Fair enough, but this doesn’t hit me as a particularly strong margin of safety if the refiners are indeed at a major cyclical peak.

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